46th Day of Credit
Banks and insurance companies:
a common path for growth
Speech by Salvatore Rossi
Senior Deputy Governor of the Bank of Italy and
President of the Insurance Supervisory Authority (IVASS)
Rome, 1 October 2014
Contents
The evolution of the world financial system
“Finance for growth” in Italy
Insurance companies and banks: strangers or companions?
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The evolution of the world financial system
The international debate on financial systems features an apparent paradox:
throughout the world there are complaints about the lack of financial support,
especially bank credit, for infrastructure and for small and medium-sized enterprises;
at the same time there is alarm about the heightened commitment of entities other
than banks to financing the real economy. The alarm stems from the fact that,
compared with banks, many of these entities are subject to less regulation and
supervision or none at all.
The two concerns arise in different contexts and for different reasons, but they
are often found together in the international fora in which the conditions of the global
economy are discussed; this gives the impression of conflicting objectives. The
impression is false, but it is important to spotlight the way in which the two lines of
analysis can be reconciled in a single, harmonious economic policy prescription.
The latest meeting of G20 Finance Ministers and Central Bank Governors ten
days ago in Cairns, Australia, provides a good example of the joint presence of these
two apparently conflicting concerns.
The final Cairns communiqué clearly expresses the unanimous belief among
the twenty countries, which produce more than 80 per cent of world GDP, that in the
present phase the critical variable for stimulating demand and increasing economic
growth is investment: investment in infrastructure, in public-private partnership; and
investment by firms and especially SMEs. If there are difficulties, as there may be, in
financing the desired additional expenditure via the markets and traditional
intermediaries, it will be necessary − the world’s leaders maintain − to promote other
financial channels, such as a transparent and efficient market for securitizations, with
a greater role for institutional investors, including insurance companies.
Another crucial passage of the communiqué was devoted to the progress of the
work that the G20 commenced immediately after the outbreak of the global crisis
with the aim of constructing a new framework of rules for the financial system, to
make it more resilient and less exposed to crises. In this context, so-called shadow
banking has always been seen as a worrisome source of risk. Shadow banking means
financing of the real economy intermediated by entities that are not banks but act, at
least in part, as if they were. This is undoubtedly the case of funds channeled to firms
by an institutional investor through securitized instruments created, for example, by a
special purpose vehicle, exactly the type of non-bank financing invoked by the
previous passage.
Can the two requirements be reconciled? As in every trade-off between risk
and opportunity, it is a question of curbing the former without sacrificing the latter.
By weakening banks, the crisis has shifted the axis of the financial system in
the advanced countries from credit intermediation to the markets, from a bank-based
to a market-based structure. The partial withdrawal of the banks, forced by more
stringent rules and the cyclical downturn to deleverage, has not only prompted an
increase in firms’ direct funding in the markets, through bond issues, but has also
made room for other intermediaries, driven in turn by the need to provide their
investors with acceptable yields in a world of very low or nil interest rates.
This development certainly entails a danger for financial stability. If part of the
traditional credit function is diverted in practice to channels that are “in the shadows”
with respect to supervisors; if the actors are willing to take greater risks to achieve
higher yields than those corresponding to today’s highly accommodative monetary
conditions; if they are free to do so because they are untrammeled by rules and
controls, the experience of the global crisis of six years ago teaches that systemic
instability is just around the corner.
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Nevertheless, the real economy does need finance. Above all when it is a
question of getting stagnant economies moving again, any financial instrument or
institution that can effectively deliver funds to entrepreneurs with technological and
business projects, especially innovative ones, is welcome. The Eurosystem recently
announced a vast programme of purchases of asset-backed securities based in part on
bank loans to SMEs.
The obvious solution to the dilemma lies in extending the perimeter of
supervision to institutions not now encompassed. This is an arduous task,
necessitating a high degree of international cooperation, given the cross-border
interconnections and the associated opportunities for regulatory arbitrage, and
requiring regulators to keep up with incessant financial innovation motivated in part
precisely by the desire to escape controls. This is the task that the G-20 assigned in
2009 to the Financial Stability Board, whose past achievements and likely future
progress were discussed in the meeting in Cairns.
“Finance for growth” in Italy
I come now to the implications of these global trends for Italy.
How to ignite a cyclical recovery in Italy? And once the upswing is under way,
how to get our economy back onto a path of lasting growth? These are questions we
ask ourselves repeatedly.
In the longer term the problem is one of production structure, competitiveness,
technology; it requires a transformation of our society to enable it again to produce
income and widespread prosperity: profound changes, twenty years overdue,
admitting no further refusal or delay. Economic and social policy in Italy has set
objectives which are generally consistent with these needs; it is pursuing them amidst
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the difficulties posed by a society many of whose members are reluctant to recognize
the paths of the future.
In the short run the problem is to lift firms’ investment decisions from the
shoals, so that they drive a recovery of demand. After six years of nearly
uninterrupted recession, Italian firms are in generally poor shape. Still, a not
insignificant number, especially among the export-oriented, are profitable and have
investment plans on hold as they wait for the uncertainties about the future to
dissipate. Others are in greater difficulty, more concerned for the moment with
surviving than investing, but they preserve a potential for recovery. Still others are
inexorably outside the market. Finally, entrepreneurial energies outside the ranks of
existing firms are pressing to take form: new cells that could replace the ones that are
no longer vital.
An efficient financial system should: help persuade the sound firms not to put
off the necessary investments any further; distinguish between the firms with
potential and those without it, supporting only the former; encourage nascent firms
and start-ups to strengthen themselves and grow quickly. To achieve all this, a
diversified and differentiated supply of finance is obviously preferable.
On a recent occasion I recalled that the Italian financial system is, instead, still
strongly centred on bank intermediation. 1 I cited some statistics: At the end of last
year bank loans accounted for 40 per cent of the total financial liabilities of
households and firms (financial debt plus corporate equity), compared with 15 per
cent in the United States, 23 per cent in France and 30 per cent in the United
Kingdom. Only Germany, another bank-centred” economy, had a share comparable
to Italy’s. Equity investment by venture capital and private equity funds, which
specialize in assisting the growth of firms, amounts to 0.2 per cent of GDP in Italy, as
in Germany, or half as much as in France and a fifth as much as in Britain.
1
“Finance for growth”, speech delivered in Sondrio at Banca Popolare di Sondrio, 12 September 2014.
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Italy’s financial system needs to evolve towards a structure in which firms are
less dependent on bank credit and markets and institutional investors play a greater
role as channels and providers of external financing for the productive economy.
The process is a difficult one, impeded by the reluctance of Italian SMEs to
open up to the capital markets, either in terms of ownership control or even just of
transparency of information. Progress along this path, which is already under way in
other economies, is particularly arduous in Italy because of the anomalies of its SMEs
compared with those of the other advanced countries, starting with their considerably
smaller size.
Insurance and banks: strangers or companions?
The need to revive private sector investment and cut the cord that often binds
the livelihood of SMEs to the availability of bank credit has led the Italian Parliament
to intervene several times in the last two years: first with the Monti Government’s
“Development Decree” in June 20122 and then with the Letta Government’s
“Destination Italy Decree” in December 2013.3 The two laws had a common
objective: to create a market for mini-bonds. On the supply side they introduced legal
and tax incentives for the issuing firms, while on the demand side they broadened the
possibilities for insurance companies and pension funds to invest in them.
The “Competitiveness Decree” 4 passed by the present Government in June is a
further step in promoting channels of finance for SMEs alternative to bank credit,
2
Decree Law 83/2012, amended and converted into Law 134/2012. The decree was recast in October by the second
Development Decree (Decree Law 179/2012, amended and converted into Law 221/2012).
3
Decree Law 145/2013, amended and converted into Law 9/2014.
4
Decree Law 91/2014, amended and converted into Law 113/2014.
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including securitized instruments with bank loans as underlying assets to be placed
with institutional investors and direct lending to SMEs by the latter. In short, this
would appear to be a move in favour of shadow banking, albeit a limited and
controlled one.
I have just two comments to make on this point, one of a general nature, the
other concerning the specific instruments chosen.
On a general level, we should not delude ourselves as to the immediate
stimulus to private investment that can be achieved by increasing the supply of
finance to firms. Most of the investment plans ready but now on hold have been
halted not by a lack of funds but by uncertainty and cautiousness. Above all, what can
unblock the plans is the dissipation of those causes by sound and efficient policies.
My second observation concerns the new form of cooperation between
insurance companies and banks prefigured by these recent laws.
Insurance companies and banks (I am talking here about traditional retail
banks) perform quite distinct functions within the economy, but they nevertheless
share some important features that have led several countries, Italy included, to group
them under the same supervisory umbrella. Both raise funds from the general
population in exchange for services rendered: transfer of risks, in the case of
insurance companies; deposit and payment, in the case of banks; in both instances the
relationship with the customer is essentially fiduciary. Both types of institution must
invest the funds gathered so as to earn income with which to meet their commitments.
Where they differ is in their time horizon: insurance companies collect premiums on
long-term contracts, whereas banks take a large number of demand deposits. This
means that an insurance company’s investment assets should preferably be at long
term; those of banks may be as well, but where they are, the bank runs the risk
implicit in every maturity mismatch.
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Insurance companies and banks have already developed some forms of
collaboration, mainly based on agreements following the bank insurance model
(bancassurance). However, these are partnerships of a purely commercial nature: the
bank makes use of its branch network and customers in order to sell the partner
company’s insurance products in return for a fee. But each party continues to engage
in its own line of business.
What we are talking about today, particularly in Europe and even more so in
Italy, is a different type of collaboration, in which insurance companies actually
supply credit, for the most part to comparatively risky and opaque customers like
SMEs. In short, the two lines of business are intertwined. Is this reasonable? Is it
proper?
The insurance supervisor Ivass, which has to turn the provisions of
Government and Parliament into operative regulations, has had to reflect on this issue
strictly from the point of view of its mandate – the prudential supervision of
insurance companies in the interests of the insured. The question we asked ourselves
was whether our rules to safeguard the prudent investment of the companies'
technical provisions were not perhaps preventing, in the light of the evolution of the
market and the regulatory framework, greater diversification of risk, which is the first
prudential line of defence, not to mention preventing the achievement of profit levels
sufficient to cover the companies’ guaranteed obligations. We answered: possibly so;
and especially considering that the imminent Solvency 2 regulatory framework will
sweep away all the old mechanical rules and replace them with methods for assessing
the risk of each investment.
Accordingly, already with the implementation of the Destination Italy decree,
we created new asset classes to accommodate both direct investment in mini-bonds
and commercial paper (up to 3 per cent of the technical provisions), and investment
via securitization (again, up to 3 per cent of the technical provisions). In addition, we
have raised the limit on exposure to a single fund within the class of “alternative
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investments” from 1 to 3 per cent for funds that invest in mini-bonds and securitized
instruments. The potential for using these wider limits, in effect since last March, is
equivalent to almost €30 billion. Although the market for these instruments has
already started to grow, interest on the part of insurance companies has so far been
negligible.
The Competitiveness decree represents a sea change, allowing insurance
companies to make direct loans (but not to individuals or micro enterprises), and to
use them to cover technical provisions, together with the related securitizations.
Ivass participated in the preparatory technical work for these new regulations,
conducted by the Ministry for the Economy and Finance and the Ministry for
Economic Development. We worked in the best spirit of collaboration, always
pursuing, as was our duty, our prudential aims. In this case as well, we felt that the
proposed opening could work in the direction of sounder and more prudent
management of insurance companies, providing them with a new “asset class” that
would enable them more easily to reach the point on the efficient risk/return frontier
most consistent with the obligations deriving from insurance liabilities.
One aspect we insisted on was that the insurance company should be
accompanied by a bank both in the initial phase of borrower selection and at the later
stages. This point was included in the text of the decree.
However, in the decree’s conversion into law the requirement that the bank and
the insurance company should form a partnership, and in particular the provision that
the bank should hold a significant economic interest until maturity, was almost
completely voided; prudential concerns were overridden by the urgent desire to
supply the economy with new credit from new institutions. As currently formulated,
the law entails a risk of “adverse selection” and “moral hazard”: at worst, that is, a
bank could foist its most impaired loans on an insurance company and then withdraw
from the partnership. To keep this from happening, insurance companies will have to
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equip themselves adequately to assess the creditworthiness of a business, as if they
were themselves banks. This is no easy task: it means having an additional technical
unit, specialized in a task that has never been typical of insurance companies. Very
big companies could possibly do it easily enough, but the smaller ones will be
exposed to the danger of being left in the lurch.
Ivass will have to authorize insurers that want to venture into this business; it
will do so by verifying the presence of technical-organizational arrangements that
enable them to form an independent judgement on the loans to be acquired or
granted.
Two days after the decree’s conversion into law, Ivass held a public
consultation on the implementing rules, which can be summed up as follows.
The insurance company will have to submit to Ivass a business plan that is
wholly contemplated within the framework resolution on investment and that
contains sufficiently detailed information to enable the Authority to make its own
evaluation and verify that the criteria set out in the law are met. In these assessments
special attention will be paid to the extent and duration of the partner bank’s
participation. If the insurance company does not intend to avail itself of the support of
a bank it must describe the organizational arrangements taken for the screening and
monitoring of borrowers and, using best banking practices, demonstrate its ability to
understand and manage credit risk.
Within the macro class of “loans,” different investment classes are envisaged,
to which specific caps and procedures are applied within the upper limit set by
Community law (5 per cent of the technical provisions). The criteria introduced by
Ivass to distinguish between the various classes are, first, the presence and
permanence of a partner bank together with a number of requirements relating to the
borrower (credit rating and the certification of the accounts).
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The class of securitizations has been broadened to include “loan
securitizations” which, along with others, can admit total investments of up to 5 per
cent of the technical provisions.
We shall see in the months ahead whether or not insurance companies show
significant interest in this new business. From our occasional contacts to date, some
interest has emerged in the funding of major infrastructure projects but little in
lending to SMEs. Given present cyclical conditions, insurance companies are
certainly driven to seek higher yields than those prevailing in traditional investment
classes, but they are well aware of the cost of equipping themselves to take on new
and very risky tasks. For higher yield means higher risk; and no one more than
insurance companies has this maxim, frequently ignored by others, inscribed in their
DNA. One way of encouraging them could be to offer a government guarantee on the
assets to be acquired. I have already said elsewhere that this would be a rational move
on the part of the public sector, because it would remedy a potential “market failure”
at a cost that will be both modest and deferred in time. 5
But insurers could also help in another way to ease the residual tensions in
credit supply, especially to SMEs, namely simply sticking to their traditional business
and increasing their coverage of the risks to which SMEs are typically exposed (fire,
theft, liability). It is no secret that the better-insured businesses – size, location and
sector of activity being equal – find it easier to access credit and at more favourable
conditions.
***
5
“Finance for growth”, op. cit.
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The insurance and the banking communities can both contribute to the
transformations of Italy’s financial landscape that are now indispensable if this
country is to return to growth. I am aware that the issues I have dealt with are small
ones. But I will not yield to the temptation to say “it will take a lot more than that”.
Let us all start with the small things within our ken. Let us avoid the danger of
confusing two different trades like the insurer’s and the banker’s, but at the same time
let us not be held back by fear of the new.
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